Stocks and bonds trade on primary and secondary markets. Most retail traders have access to the latter. Let’s take an in-depth look at secondary markets.
What is the secondary market?
The secondary market is where investors can buy and sell securities between each other, rather than the issuing entity. It’s secondary to the primary market, where stocks and bonds are sold for the first time by issuers to investors.
In a primary market, the issuers can set their own prices. But in the secondary market, prices are driven by supply and demand. For example, if traders believe in the future of a company and buy its stock, its share price will rise.
Who trades on the secondary market?
Entities and individuals that trade on the secondary market include:
- Retail investors
- Financial intermediaries – such as trading providers
- Institutions – such as insurance companies, banks and mutual funds
What instruments trade on the secondary market?
The instruments that trade on secondary markets include equities – such as shares and exchange traded funds (ETFs) – as well as fixed-income instruments, such as bonds.
How does the secondary equity market work?
A secondary market works through various platforms and marketplaces, which gives the shareholders of a company – whether they’re individuals or institutions – the chance to sell the shares to another investor.
Usually, investors in the primary market can’t liquidate their positions in the secondary market immediately. There’s often what’s known as a ‘lockup period’ before transactions can occur – typically of 90 or 180 days.
The secondary market serves a few vital purposes:
- Accessibility – retail traders and investors can trade shares not just institutions
- Liquidity – trading shares is easier and faster in secondary markets given the greater number of participants
- Transparency – all transactions on the secondary market are stored in order books, making them visible to other market participants
- Accountability – public companies have to disclose information about their earnings and finances
Is a stock exchange a secondary market?
Yes, a stock exchange is a secondary market. These are the public marketplaces for buying and selling the shares of companies, as well as ETFs.
Examples include New York Stock Exchange (NYSE), London Stock Exchange (LSE) and Australian Stock Exchange (ASX).
Buying and selling shares on the secondary market
You’d buy or sell shares on the secondary market based on your prediction of whether a stock will rise or fall in value.
- You buy, or go long, if you think that a share price will rise
- You sell, or go short, if you think that a share price will fall
What is the secondary market for bonds?
The secondary market for bonds is where contracts are bought and sold between investors through brokers, without the issuer’s involvement.
Although it works in much the same way as stocks, the difference is in the factors that impact their pricing.
While bond prices and yields fluctuate in line with supply and demand, the contracts have fixed principals (initial investment) and coupon rates (interest paid at fixed intervals throughout the contract’s maturity). So, generally bonds are less volatile than stocks unless rates change.
If interest rates rise, the price of bonds on the secondary market usually falls, as newer issues come with greater incentives for investing – decreasing the demand for the older bonds. This is known as interest rate risk. The longer the duration of a bond, the more sensitive its price is to changes in interest rates, as there is a greater chance it will be exposed to the risk.
Conversely, if rates fall, the price of bonds on the secondary market will usually rise, as the higher interest rates become more attractive.
How are bonds traded on the secondary market?
Most bonds on the secondary market will be traded through exchanges, and facilitated by stockbrokers and banks.
As bonds are essentially loans from investors to governments or corporations, when the contracts are traded on the secondary market, all the terms of the agreement are transferred from the original holder to the new buyer.
The transactions will be recorded so that the issuer can keep track of who they owe capital to.
Why should a bond issuer care about secondary market liquidity?
When bonds trade on the secondary market, issuers should still pay attention given it is a direct indicator of confidence in their ability to repay their loans.
A bond that is trading below its intrinsic value on the secondary market means that there are doubts about the issuers’ ability to uphold their obligations. This can make it more difficult for the issuer to refinance at better terms with banks or other lenders, and secure loans in the future.
Apart from those more direct impacts, a lower bond price can impact a company or government’s reputation.
For example, the UK government announced plans to cut tax in September 2022 as part of its trickle-down economics policies. In theory, this should have increased investment in UK bonds as yields would need to be raised too.
But the credit agency Moody’s stated that the unfunded tax cuts were credit negative and would permanently weaken the UK’s debt affordability. The market sentiment soured and forced the UK government to abandon its plans.